CH1: The Goals and Functions of Financial Management 1.1 – What is Finance? Finance- about making decisions that focus on creating value within the firm and builds upon the disciplines of economics and accounting. o Economics- provides theories about economic system and decision making o Accounting- supplies financial data and data analysis tools. Finance has evolved from a pure descriptive discipline through an analytical, decision-oriented discipline to now a discipline used by financial managers. Finance tries to help financial managers to answer (i.e. make decisions about) the following questions made within a risk-return framework: o What long-term investments or projects the firm should undertake? (capital budgeting decision) o How should the firm pay for these assets? By issuing equity or debt? (capital structure decision) o How much cash or inventory should the firm carry? How much trade credit should the firm provide or use? (working capital management decision). 1.2 – Goals of Financial management Primary goal: shareholder wealth maximization (firm is owned by them) o Should be measured in terms of market share price, which is a value that investors collectively are prepared to pay. The closest alternative – profit – fails to consider risk and timing and more importantly, it is almost impossible to accurately measure profit. May conflict with interests of management (their compensation) and social/ethical goals. Agency theory- potential conflict between shareholders and managers. Tradeoffs exist among agency costs of monitoring management actions, allowing sufficient discretion for management and designing compensation packages to motivate management. The goal can be consistent with a concern for social responsibility. Firms should take socially desirable actions even if certain actions like pollution control may at times conflict with this goal. Managers should strictly follow the rules of fairness and honesty. Insider trading and manipulation of financial results have been proven to serve the firm/shareholders as well as the management no good. 1.3 – Functions of Financial management Some are performed on a daily basis and others are less routine. All are carried out with the intention to proper balance profitability against risk. Functions: o Corporate finance o Banking o Securities Trading and Underwriting o Money Management o Financial Planning o Risk Management (Insurance) 1.4 – Forms of Organization Sole Proprietorship- one owner; largest in actual number but smallest in total sales revenue. Partnership- two or more owners Corporation- legal entity unto itself; smallest in actual number but largest in total sales revenue. 1.5 – Role of Financial Markets Financial markets- vast global network of corporations, financial institutions, governments and individuals that either need money or have money to lend or invest. o Public financial markets- for governments to borrow funds for public activities. o Corporate financial markets- for corporations to raise funds. The effect of managerial decisions on the value of the firm is realized in financial markets. Structure and Functions of Financial Markets: o Money markets- deal in short-term securities (less than a year; ex: treasury bills, commercial paper) o Capital markets- deal in long-term securities (greater than 1yr; ex: common stock, preferred stock, corporate bonds, government bonds) o Primary market- where a firm issues new bonds or shares to raise new funds. o Secondary market- where investors buy and sell (trade) outstanding bonds/ shares. Risk-Return Tradeoff o Increased Profitability = Increased Risk o Decreased Profitability = Decreased Risk E.g. investing in stocks vs. savings accounts Stocks may be more profitable but are riskier Savings accounts are less profitable and safer o A financial manager must choose appropriate combination of potential profit (return) and level or risk (safety). Securities in Financial Market o Common Stock (Common Share) = Ownership or Equity Shareholders OWN the company o Bond = debt or liability Bondholders are OWED money by company Financial markets determine value and allocate capital to the most productive use on a riskreturn basis. Debt is an important component of a firm’s capital structure. o Too much debt can erode the firm’s cash flow and increases the firm’s risk. o Interest rates or yields help establish the allocation of capital o Greater risk increases the spread between inflation and yield 1.6 – Summary and Conclusions Finance links economics and accounting Primary goal is to make decisions to maximize shareholder wealth. However, managers may pursue their own interests instead of those of shareholders. Agency theory- studies the conflicts between the shareholders and management. Financial managers make investment and financing decisions. Financial markets are where financial managers raise funds and are given feedback about the effect of their decisions.